Hybrid QDIAs Can Help Preserve Retirement Income

There are different ways the
industry is defining hybrid qualified default investment alternatives
(QDIAs), but generally it is when a certain segment of a defined
contribution (DC) plan participant population is first defaulted into
one vehicle, and then later defaulted into a different vehicle when
certain triggers are met, according to James Martielli, head of Vanguard
Defined Contribution Advisory Services, in Malvern, Pennsylvania. The
triggers for changing defaults could be account balance or age.

Holly
Verdeyen, senior director, defined contribution strategy at Russell
Investments in Chicago, adds that a hybrid QDIA blends multiple types of
QDIAs, such as a target-date fund (TDF) or balanced fund with a managed
account. For example, she says, a younger participant may be defaulted
into a TDF or balanced fund then moved to a managed account based on age
or what she calls “funded status,” which is the amount of income
replacement in retirement the participant’s account balance would
provide.

“TDFs and balanced funds tend to keep static allocations
until participants are in their late 30s or early 40s, then derisking
occurs,” Verdeyen says. She notes that an age trigger would probably be
10 to 15 years prior to retirement, and a funded status or account
balance trigger would be when someone is approaching fully funded status
based on their retirement income need. “A managed account can preserve
that funded status better than a TDF,” she contends.

According to
Verdeyen, a properly structured managed account will be able to adapt
to changing participant circumstances and market conditions; if market
conditions lower a participant’s funded status, a managed account could
adjust for that. Likewise, if market conditions improve a participant’s
funded status, a managed account could derisk, like a pension plan, to
preserve the higher funded status. “A TDF will keep rolling on its
glidepath, but a managed account could change with market conditions,”
she says.

As for participant circumstances, Verdeyen notes that
if a participant gets a raise, which would help his or her funded
status, a managed account portfolio could be adjusted. The same is true
if the participant stopped contributing to the plan, hurting his or her
funded status.

NEXT: To default or not to default

Martielli says a TDF series and a managed account program can be complementary
in a DC plan investment lineup. “A managed account can be good for
participants, but they are particularly effective for those who are
engaged and will provide the managed account manager with more
information, such as risk preferences, assets outside of the plan, and
desired income replacement ratio,” he says. “So we believe there is a
place for managed account programs in a DC plan investment lineup.”

But
without that engagement and without knowing a lot about participants,
defaulting participants into a managed account program when they reach a
certain age or balance will increase costs for them, Martielli says. He
notes that managed accounts are two or three times more expensive than
TDFs. “However, the benefit of a hybrid QDIA may be uncertain,
especially for non-engaged participants who don’t reveal customization
drivers,” he adds. “If we know nothing more than age, the most important
thing is a gradual derisking as participants age and approach
retirement.”

“We are still big believers that TDFs are the most
appropriate QDIA option for plans,” Martielli states. He notes that
Vanguard’s How America Saves study
finds that of the 53% of participants who use professionally managed
funds, 46% hold a single TDF, 49% hold a single target-risk fund or a
balanced fund and 4% use a managed account program.

According to PLANSPONSOR’s 2016 DC Survey, 65.7% of plans use a TDF as the default investment option, 10.9% use a balanced fund and 7% use a managed account program.

Verdeyen
says with a hybrid QDIA, the managed account provider is able to get
more information, due to technology, from recordkeeping platforms. They
can automatically pull more data such as a participant’s salary, gender
and contribution amount.

However, Martielli argues Vanguard found
in its research that the biggest levers in portfolio customization are
risk preference and outside assets, and managed accounts can’t get that
from a participant who is not engaged or from the recordkeeper.

Verdeyen
concedes that a managed account cannot always get outside assets from
the recordkeeper, but she says, with managed accounts, it is easy for
participants to provide that information. “Participants are given their
funded status and encouraged to provide additional information, and
technology makes that easy,” she says.

“Managed accounts can be a
complement to TDFs and should be a part of a DC plan’s investment
lineup, but we are not a big believer in defaulting to them if
participants are not going to be engaged and give the manager critical
info to make a customized portfolio,” Martielli says.

NEXT: Costs and other considerations

“When talking about defaults, the only thing we know for sure when it
comes to returns is the costs participants are going to pay, so we
would recommend TDFs as an appropriate lower-cost asset allocation,
absent knowing additional information in order to customize managed
accounts,” Martielli says.

Verdeyen concedes that
costs for managed accounts could be a prohibited factor to hybrid QDIAs,
so it is an important consideration for plan sponsors. But, with
enhanced service and customization, there is some value with managed
account that warrants slightly higher fees. “Managed accounts include
advice costs which can’t be controlled, but investment costs can be
controlled by deciding which underlying investments are used,” she says.

Verdeyen adds that since managed accounts keep working through
retirement, it makes sense to pair them with a TDF that goes to
retirement so participants will have a “through retirement” strategy.

She
also says DC plan sponsors might want to consider whether a managed
account makes sense for the entire plan as a default, as they offer
several benefits to younger and older participants. Many younger
participants change jobs often, and managed accounts offer the ability
to accommodate outside assets. And, customizing asset allocation based
on market conditions and changing participant circumstances is an
advantage to the young and old alike.

In addition, Verdeyen says, managed accounts report participants’ funded
status even when they are far from retirement, so they can do something
about it and make decisions all along their working career.